Hon. HARRY F. BYRD, Jr., AMERICAN BANKERS ASSOCIATION, Chairman, Subcommittee on Taxation and Debt Management, Committee on Finance, U.S. Senate, Washington, D.C. DEAR SENATOR BYRD: This letter is being written as a followup to the testimony of Leif Olsen on behalf of the American Bankers Association before the Subcommittee on Taxation and Debt Management of the Committee on Finance of the United States Senate on May 17, 1977. At that time you requested our views on the integration of corporate and personal income taxes. This subject was considered very carefully by a special task force on tax reform that has been assembled by our Association. This task force includes members of our Association's Economic Advisory Committee, Bank Taxation Committee, and the Executive Committee of the Trust Division. We discussed three methods of integration. First, full integration through the elimination of the corporate income tax, and the treatment of all corporate income as if it were earned income of the shareholders. This proposal has too many problems and should not be considered at this time. Partial integration was discussed in terms of two other proposals. The first would be to allow corporations to deduct dividends paid from their gross income in their determination of taxable income. This deduction would be allowed for dividends paid to domestic tax exempt organizations, but not for these paid to foreign shareholders unless reciprocal treatment were afforded by treaty. The second method would be to allow shareholders to use corporate tax payments on income paid out as dividends as a tax credit against their personal tax liability, after these tax payments have been included or "grossed up" in their personal income. At the current time, our Association cannot take an official position on any of these methods because we do not know what other proposals will be involved in tax reform legislation. Subject to this qualification, our task force reached a tentative consensus in favor of the dividend deduction method for the following reasons: 1. Simplicity of administration There would be no need to estimate taxes at the time dividends are paid. Shareholders would not have to be re-educated to include the gross-up in income and take the credit. No problems arise from audit adjustments for past years, partial-year shareholders, or the variations between current and deferred taxes. There would be no necessity of elaborate record keeping to ensure the correct treatment of the credit. The records on foreign shareholders are substantially the same as those that must now be kept for withholding tax purposes. 2. Incentive to increase dividends The dividend deduction approach would provide managers and shareholders with an incentive to increase dividends, thus passing on the tax savings to the shareholders for reinvestment. With a shareholder credit approach, in order for the dividend-paying corporation to retain any benefit directly the dividend must be cut, although the shareholder may still receive a higher gross dividend than formerly. 3. Ease of Phase-in Under a dividend deduction alternative the phase-in is simple, with the burden of keeping up with the phase-in changes falling on professional managers rather than individual shareholders. It would also provide time for a corporation to change its business mix as necessary to accommodate the increasing deduction. 4. Preservation of existing incentives Congress has provided a variety of tax incentives to corporations for purposes seen to be of economic or social benefit to the national interest. With a dividend deduction, these incentives are more likely to be preserved than with a shareholder credit, which might be structured in such a way as to destroy the efficacy of present or future incentives to the extent of dividend payouts. 5. Enhancement of capital formation The dividend deduction approach would generate more capital formation for two reasons. First, the deduction guarantees a tax savings at the marginal or statutory rate, rather than at some lesser gross-up factor, as might be the case under some forms of shareholder credit. Second, the capital thus formed is auto matically reinvested unless dividends are increased; it is likely that somewhat more earnings would be retained than under a shareholder credit system, and thus less would be lost by any propensity of shareholders to spend rather than reinvest dividend income. In general, we see many advantages to a dividend deduction system although we would not be opposed to a carefully constructed shareholder credit system which took account of the reservations listed above. We share the concern expressed by many observers about the effects of these proposals on Treasury revenues. Indeed, economic stability will be a crucial element in any program to enhance capital formation. On balance however, capital formation will only be enhanced if the net tax burden on the corporate sector is lightened, and tax incentives are altered to favor capital investment. To accomplish this we urge the Committee to also consider other forms of tax incentives. Areas for consideration might be the investment tax credit, accelerated depreciation, lowering corporate tax rates, and indexing tax rates to account for inflation. Sincerely, GERALD M. LOWRIE. STATEMENT OF ALAN S. DONNAHOE, PRESIDENT AND CHIEF EXECUTIVE OFFICER, MEDIA GENERAL, INC., RICHMOND, VA. RECOMMENDATIONS 1. Establish a tax ceiling of 50 percent on all income, whether earned or unearned The present maximum of 70 percent on unearned income is absolutely punitive, and strongly discourages any investment that yields income in the form of either interest or dividends. 2. For capital gains of more than one year, deduct the gain due to inflation, and tax the remainder as ordinary income Prices in this country, for example, have risen by about 75 percent in the past decade. Thus a home worth $40,000 10 years ago will have risen to $70,000 today due to inflation alone. Only the profit beyond $70,000 should be taxed. It is grossly unfair and inequitable to make people pay a tax on inflation itself, which is the cruel hoax inflicted, in effect by our present system. 3. Permit corporations to deduct dividends as a business expense The typical corporation now pays 48 percent of its income in federal income taxes. If it pays out the remaining 52 cents per dollar in dividends, the taxpayer can pay up to 70 percent of this in taxes, or 36.4 cents per dollar. Thus he is left with 15.6 cents of the original corporate income dollar; and the federal government has taken the other 84.4 cents in taxes. And the situation is even worse, of course, when state taxes are included as well. With such a negative tax system as this, it is not surprising that the United States is a laggard in investment among industrialized nations, and that we are constantly plagued with high unemployment and inflation. It is significant that the median price/earnings ratio of all listed stocks on the New York and American Exchanges, along with principal OTC companies, is now 7.8. This means that the typical company, selling stock to get additional capital, must earn an after-tax return of 12.8 percent on that capital just to break even in terms of earnings per share. Taking account of the federal income tax, this must be doubled to a return of 25 percent on a before-tax basis, just to break even. Is it surprising. in view of this, that capital investment is being severely retarded in the United States? If dividends could be treated as a business expense, it is reasonable to assume that most corporations would double their dividends immediately. As a result, it is a virtual certainty that stock prices would rise sharply, thus providing all companies with far greater inducement to increase their capital spending. This effect would be even stronger, of course, if my other two recommendations were also adopted-a 50 percent maximum tax on income, and deduction of inflation before any tax on capital gains. 4. Revise the ERISA law to stop the discrimination that it has created against medium and smaller-size companies among institutional investors A miserable by-product of ERISA has been to give pension and other fund managers a ready excuse for not investing in anything other than giant companies. They claim, under ERISA, that they can be held guilty of negligence for investing in any company with, say, less than $100 million in annual revenue, on the theory that there is greater risk in any smaller company of this type. The effect of this is to further limit the access of these smaller companies to the capital market, and thus sharply reduce their growth potential. In many and perhaps most instances, over time, about all they can look forward to is being gobbled up by some larger, acquisition-minded company. So legislation intended for another purpose entirely has had the effect of putting these smaller companies at a huge disadvantage in competing with larger firms for available capital. Clearly, this inequity should be eliminated by an appropriate amendment to the ERISA legislation as quickly as possible. SUMMARY These simple changes would provide an enormous stimulus to capital investment in this country, and go a long way towards redressing the present imbalance in our tax system which strongly favors consumption versus savings, through the heavy penalties imposed on investment income. With normal taxes on the additional investment and income thus generated, the federal government should more than recoup any initial losses in tax revenue in a relatively short period. Thus, properly viewed, these are revenueproducing measures which in time should lead to a balanced budget, along with additional funds to meet other needs of the country. And, most importantly, these simple changes would set this country on the road to full employment and reduced inflation. The only real argument against the recommended program is that it runs counter to the soak-the-rich philosophy that seems to have great popular appeal. But all of this is utterly spurious because the people really hurt by our tax system are not the rich but rather the middle class, professional people, corporate executives, and entrepreneurs. Precisely the people, in other words, who can contribute most to the vigor of our economic system. And when these people are harassed and their incentive is reduced, then everyone in the nation suffers accordingly. The revenue from excessive taxes on this group is utterly trivial in terms of the economic damage that is wrought thereby. The clearest example of this, of course, is England, where punitive taxes and related policies have created economic stagnation, growing unemployment, high inflation, and ever-increasing social conflict. POSTSCRIPT Media General has been a public company, chartered in Virginia, since 1966. In its relatively short history as a public company, it has grown in assets from less than $14 million to more than $191 million, in revenue from $18 million to $199 million, and in stockholders' equity from $11 million to $116 million. Media General today owns daily and Sunday newspapers in Richmond, Virginia; Winston-Salem, N.C.; and Tampa, Fla.; along with broadcast, printing, and related subsidiaries. It also owns the Garden State Paper Company which produces about 12 percent of all the newsprint manufactured in the United States through a unique recycling process which utilizes old newspapers as the basic raw material without the need for any virgin fibre. I have been president and chief executive officer of Media General throughout its history as a public company and I have personally approved and recommended more than $100 million in capital expenditures throughout this period-a substantial investment for a company our size. This background is provided simply to indicate that I have had some personal experience in the area of capital investment, and the decision-making process that is involved therein. ALAN S. DONNAHOE. STATEMENT OF THE FINANCIAL EXECUTIVES INSTITUTE TAX SYSTEM CHANGES FOR CAPITAL FORMATION AND ECONOMIC GROWTH Financial Executives Institute is the recognized professional association of 9,000 senior financial and administrative executives of more than 5,000 business organizations, representing a broad cross section of American national and international industry. We believe that the substantially increased level of capital investment by business that will be required over the next decade should be encouraged by the following capital formation provisions in the tax system. 1. A flexible capital recovery allowance system permitting capital investments in machinery and equipment to be recovered over as short a period as five years, and a substantial reduction in the capital recovery period for industrial and commercial buildings, with recovery in both cases starting as progress payments on new construction are incurred. 2. A permanent 12 percent investment tax credit for all capital expenditures. 3. Immediate writeoff of pollution control expenditures at the taxpayer's election. 4. Elimination of minimum tax on corporations. 5. Mitigation of the income tax burden on capital gains. These changes are needed in order to provide adequate employment opportunities for a growing labor force, to reduce inflationary pressures by increasing capacity to meet consumer demands, to replace and modernize obsolete and worn out facilities, to develop new energy sources and to meet environmental and safety standards. 1 The magnitude of the capital requirements with which we are faced is apparent from separate studies carried out in 1974 by General Electric Company 1 and the New York Stock Exchange. In these studies, gross private domestic investment (including residential structures and inventory accumulation as well as business fixed investment) for the period 1974 to 1985 is estimated to be about $4.5 trillion-three times the $1.5 trillion total for the previous twelve years. Even when stated in current dollars to eliminate the effect of inflation, the 1974 to 1985 requirement is still roughly 1.5 times greater than that of the prior period. The critical problem.—The critical problem to be overcome, if these projected capital requirements are to be met, is that of providing funds in such large amounts. For example, the New York Stock Exchange study previously referred to projected a potential capital shortfall of $650 billion through 1985. A more recent study, commissioned by Financial Executives Research Foundation,' found that, assuming no change in current price level, there will be a $816 billion shortfall of accumulated savings (i.e., available capital) over the next decade. At an inflation rate of three percent a year, the shortfall will increase to $983 billion; at an inflation rate of five percent, the shortfall will increase to $1.1 trillion. A report issued by the Staff of the Joint Committee on Taxation in March 1977 noted that "there are several reasons to be concerned whether the United States will have an adequate amount of capital accumulation." The Committee's Staff found that "the growth rate of the labor force has not been matched by growth of capital investment." Growth of private plant and equipment (excluding pollution control investment) declined from a rate of 4.3 percent in 1965-70 to a projected rate of 2.5 percent in 1975-77. Growth of plant per worker fell from 2.6 percent in 1965-70 to a projected rate of 1.0 percent in 1975-77. Moreover, inadequate plant investment was found to be a major factor in a decline in the growth rate of productivity, and in a decline in the growth rate of real wages. Contributing to the problem is the fact that the ability of American industry to generate funds has been seriously inhibited by the deterioration of real corporate profits due to inflation and by an increased reliance on debt financing. Analyses prepared by the Department of Commerce indicate that although after-tax corporate profits were widely reported as "record breaking" in 1976, "real" profits, after adjustments for inventory profits and under-depreciation of assets, actually declined. While reported after tax profits of non-financial companies for 1976 totalled $84 billion compared to $47 billion in 1966, an apparent 77 percent increase, real profits when adjusted for inflationary factors actually declined by 37 percent, and this despite a substantial increase in the volume of business. 1 Business Capital Requirements-1974-1985; by Reginald H. Jones; Financial Executive: November 1974. "The Capital Needs and Saving Potential of the U.S. Economy"; The New York Stock Exchange: September 1974. 3 "The Effects of Tax Policy on Capital Formation"; by Norman R. Ture and B. Kenneth Sanden; Financial Executives Research Foundation: 1977. Page 38. 4 "Report on Tax Policy and Capital Formation"; by Staff of Joint Committee on Taxation for House Ways and Means Committee Task Force on Capital Formation: March 1977. 1.2., 3. Retained earnings available for reinvestment by business, restated to account realistically for inventories and depreciation, show a decline from $26 billion in 1966 to $13 billion in 1976-a period in which real gross National product (the total economy) grew 29 percent." The deterioration of real business profits and retained earnings, along with the depressed state of the equity markets, has forced corporations to rely more and more on debt financing. From 1965 to 1974 non-financial corporations raised a total of $267.4 billion of long term funds of which long term debt accounted for 83 percent. This gave rise to an increase of outstanding debt reflected on corporate balance sheets of $220 billion ($141.4 to $362.3).o Effects of tax policies.-Federal tax policies affect capital investment decisions by determining the after-tax earnings and cash flow available for investment and by establishing incentives or disincentives for future investment. Recognition of the important role played by such policies in helping business to generate internal funds to finance capital investment led to the enactment of accelerated depreciation in 1954 and the investment credit in 1962, the issuance of the depreciation guidelines in 1962 and the Asset Depreciation Range (ADR) system in 1971. Despite these changes, American businesses still bear a heavier tax burden on capital than do businesses in other leading industrial countries, which have generally adopted more favorable capital recovery allowances than the United States. An American firm using both ADR and the investment tax credit can recover 54.7 percent (or 60.7 percent with the temporary 10 percent credit) of the value of new investments over the first three years. By comparison, the allowances in other nations within the first three years are as follows: ' In addition, depreciation allowances based on historical costs have been seriously eroded by inflation and are thus inadequate to provide funds for replacements of existing assets. In an article published by Machinery and Allied Products Institute in December, 1974, entitled "Inflation and Profits", George Terborgh makes a comparison on current cost double-declining balance depreciation of non-financial corporations with depreciation allowed them for income tax purposes for the years 1965 to 1973. Mr. Terborgh's analysis shows an understatement of capital costs for 1973 of $9.3 billion and a cumulative understatement of $43.1 billion over the nine year period. The comparable figure for 1974, based on a 9-month actual, was $11.2 billion. A prime example of an industry suffering from the erosion of depreciation allowances by inflation is the steel industry. The extent to which inflation has deflated the dollars recovered by the steel industry through statutory capital recovery allowances since 1953 is graphically set forth by the American Iron and Steel Institute in its revised study entitled "Steel Industry Economics and Federal Income Tax Policies" (June 1975). This AISI study projected a trend of steadily increasing deficiencies in statutory allowances. Another drain on available funds is the demand for capital to protect the environment which has been steadily increasing and can be expected to continue to increase in the future. According to the U.S. Department of Commerce Survey of Current Business, non-farm business spent $5.6 billion for air and water pollution abatement plant and equipment in 1974, $6.5 billion in 1975 and p'anned to spend 7.3 billion in 1976.8 These amounts represented 5.0 percent, 5.7 percent and 6.1 percent, respectively, of total expenditures for new plant and equipment. Pollution control expenditures are obviously different from those made for productive facilities. Even though resulting in physical property, they are generally not income producing and, in addition, increase annual operating and maintenance costs. Survey of Current Business (February 1977) and Business Conditions Digest (March 1977)-Department of Commerce. Statement of Treasury Secretary William E. Simon-Senate Finance Committee Hearings. March 1976. 7 Ture and Sanden, op. cit., page 150. 8 Survey of Current Business (July 1976, page 14). |